Asset Allocation For Young Investors

For new investors, there’s no more important concept to master than asset allocation; how to diversify your portfolio with a mix of stocks, bonds, and cash.

Anybody can — and should — be an investor. You don’t need to study every issue of the Wall Street Journal or even be a “math person” to put your money to work for you in the stock market.

There are — however — a few important concepts with which every investor should become familiar. Here, let’s talk about asset allocation.

First: What’s an asset?

An asset is anything of value: Cash, real estate, or even vintage cases of scotch. In investing, there are different asset classes (groups of similar investments).The three main asset classes are:

Cash

Stocks

Bonds

Others include real estate, private equity, natural resources, foreign currencies, and more. For the purposes of this article we’ll focus on cash, stocks and bonds and lump all the other assets into “alternatives”.

Understanding asset allocation: The grocery basket analogy

Here is an analogy that explains exactly how asset allocation works:

When you go to your local grocery store, you grab a shopping basket. The basket is like your total investing portfolio; it’s where you place all the items you are going to purchase (or all of the assets you buy).

The objective of asset allocation is to broadly diversify your investment portfolio, just like you probably diversify your diet. (Even if you love cheeseburgers, you don’t want to eat them all the time because you’ll miss out on nutrients in other foods.) So you fill your cart with a variety of foods.

As you shop, you don’t organize your groceries yet — you just throw it all in there. But you can easily categorize your purchases by food group: milk and eggs into one bag, meat in another, and fruits and veggies in another.

Each of these food groups is akin to an asset class in your portfolio. You may hold dozens of different investments and within each of them are stocks, bonds and cash. You can’t quickly tell by glancing at your grocery basket how many veggies versus how many sweets you have, but you can (and likely do) separate it out in your head to know you’re buying food for a balanced diet.

Just as it’s not healthy to eat only hamburgers, in investing it’s not healthy to be overly invested in one asset class. The goal of proper asset allocation is to provide the ideal mix of investments that gets you the greatest long-term gains for a tolerable amount of risk.

Why asset allocation matters

The goal of asset allocation is to get a return on your money while managing risk.

There will, of course, always be market risk — the risk that an entire market will decline. We saw a good example of market risk from the fall of 2008 to the spring of 2009. Every asset class declined across the board. Stocks bonds, mutual funds, and real estate all took a nose dive. Money market funds—considered the safest of safe investments— even lost money. The bottom line is you can’t eliminate risk entirely. (And leaving your money is a savings account isn’t the answer! Over time, inflation will outpace the measly interest rates savings accounts offer and leave you with a negative return on your money.)

The good news is that with smart asset allocation, you can reduce some investing risks, specifically unsystematic risk (the risk that lies within one particular investment).

Investing in any individual stock or bond leaves you vulnerable to the risk that the particular investment could go down in value. Diversification eliminates this risk and gives you the opportunity to make money with one asset class even while another declines.

Asset allocation strategy 101

Choosing an appropriate asset allocation depends on two things:

How long you have to invest

How much risk you can tolerate

In terms of retirement, your asset allocation will look very different when you’re 25 and when you’re 75. In your 20s, you likely have 30 or 40 years to invest before you need that money back, so you can choose aggressive investments that have high growth potential but also higher risk. In retirement, you no longer have decades for your money to grow and you will need to withdraw money every year. You can’t afford for your portfolio to have a bad year in which it loses 20 percent, so you’ll choose more conservative investments that don’t return as much but are less risky.

A simple starting point

There’s a common formula (and many variations) out there to find your target asset allocation for retirement savings:

100 – Age = Percentage of stocks

So if you’re 20, you would invest 80 percent in stocks and 20 percent in bonds. If you’re 60, you would invest 40 percent in stocks and 60 percent in bonds.

This formula is an oversimplification, but I like it because it gives you the idea of how your asset allocation should change as you age. Some young, aggressive investors will want to invest in 90 or even 100 percent stocks whereas many conservative investors will never own 70 percent stocks at age 30, and that’s OK.

But…asset allocation is about more than stocks and bonds

If you’re new to investing, finding a comfortable allocation between stocks and bonds is a good start. For example, if you don’t hold any bonds at all, you might buy a bond index fund to offset your stock holdings.

To become a more skillful investor, however, you’ll want to look beyond these broad classes and consider the kinds of stocks and bonds you’re holding. You might own 80 percent stocks but find that all of your stocks are domestic companies. As a young aggressive investor, think of the big wide world outside of the United States. International stocks include economies that are younger than ours and growing at a faster pace. This presents an incredible opportunity for investors to earn huge returns over the coming decades, but foreign stocks may be more reactive to international politics and events, making them riskier.

Choosing your ideal asset allocation

Only you can decide which asset allocation you’re comfortable with. Furthermore, if you are investing for different goals, you should maintain different target allocations for each goal. For example, you’ll want a more aggressive allocation for retirement and a more conservative allocation for a new house fund that you plan to use in the next five years.

Here are some questions to help you decide on the best allocation for you:

1. How soon will you need the money?

If you’ll be investing for more than 20 years, choose an aggressive (mostly stock) allocation. If you’ll need the money sooner than that, invest in a mix of bonds and stocks. If you need the money in between two and five years, stick with mostly bonds. If you might need the money within a year, stick with a cash savings account.

2. How comfortable would you be with losing 30 percent of your money in a year?

Although rare, the worst years in the stock market could result in a loss of up to a third of your money. That’s tough for anybody — but aggressive investors see it as a bump in the road that will be overcome by future gains. If, however, you know you would freak out over such a loss, consider weighting your portfolio with more bonds, which can soften the blow of the stock market’s more volatile up and downs.

3. Are you on track with your retirement savings?

Contributing enough money to your retirement account can reduce the need to be overly aggressive with your investments. If you make regular retirement contributions (and plan to so indefinitely), you can feel good about choosing a moderate allocation that avoids wild ups and downs.

If, however, you’re behind in contributing to your retirement accounts and playing catch up, a more aggressive investment strategy may be necessary to attempt to make up for lost ground. In this case I’d recommend speaking with a financial advisor to create a solid plan for how you can reach your retirement goals through a combination of saving and aggressive investing (so you avoid making any costly mistakes on your own).

How to calculate your current asset allocation

Your investment portfolio likely contains one or more mutual funds or exchange-traded funds (ETFs), each of which owns hundreds of different investments. Some of these funds, such as an index fund that tracks the S&P 500, may contain only one asset class (stocks). But others may be managed funds that hold stocks, bonds, cash and other asset classes. Fortunately, technology makes it easy to “x-ray” all of your investments and find your current asset allocation.

The first place to check is in your brokerage online account, as most provide a snapshot of your current asset mix. The other tool that I’ve fallen in love with is Personal Capital. It’s a free investment management app that aggregates all of your investing accounts from multiple brokers. Personal Capital provides a beautiful graph of your asset classes including domestic and foreign stocks, foreign and domestic bonds, cash and alternatives.

What you can do now

It’s a good time to check up on your asset allocation to see if your portfolio is where you want to be.

If you notice, for example, that your portfolio is too heavily weighted in one asset class, you should consider adding investments of another class. You can simply buy more of an asset class or exchange one investment for another until you achieve your desired allocation.

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

I just wanted to thank you for writing an article that goes beyond the basics for those in our age group. I’m very interested in finances, am constantly reading books and magazines about it, but often have a hard time finding articles which go beyond the typical advice for younger adults. For instance, I subscribe to Money magazine and over half of the articles are geared towards those on the verge of retirement.

I was glad to see that you also invest in Fidelity’s International Discovery Fund. I found that about a year ago when rolling over my old 401K to a Roth. I have been happy with it so far, especially considering the markets right now.

Wow, thanks for giving me a good first look into investing. As an 18 year old ambitious high school student the only people i ever get any info from are my teachers, some of them dont know what they are talking about, others are pretty knowledgeable. Im am now thinking about going with the good aggressive strategy.

The standard caveat “past returns are no guarantee of future results” ought surely to apply to the question of political stability as well. Are “foreign” countries really likely to be less stable than the USA over the next 30 years? For one thing, at the risk of stating the obvious, not all “foreign” countries are created equal. (By “foreign” did you mean Somalia? or Brazil? or Japan?) And secondly, I wouldn’t be smug about assuming that the USA is the single-least likely country to have major domestic unrest over the next 30 years.

Around 1/2 of the world’s market cap is in US companies… which means around 1/2 is NOT in US companies. Am I the only one imagining that the latter proportion is likely to go up significantly over the next 30 years?

The author of this article probably shouldn’t be giving this advice or, at least, people should take it with a grain of salt. The author presents a false dichotomy between growth and income assets when its actually growth and value that are opposing forces (although, still not a true dichotomy). This concept is very basic to investing and the lack of understanding or knowledge about value stocks that the author demonstrates is a huge gap because Small Value stocks have been the most rewarding asset class – even more than Small Growth – over the last 50+ years.

I think the author needs to make clear what exactly ETFs are – specifically that they can be based on a bond exchange or a stock exchange, and can be extremely risky or very conservative. You can’t really say that a conservative portfolio usually contains ETFs or that an aggressive strategy will only have 5-10% ETFs and bonds. I am 25 and have a very aggressive asset allocation, but my holdings are all held in ETFs (40% us stocks, 40% foreign, 10% bonds, 10% TIPs). There are even companies filing to run the first actively managed ETF.

@Jon – Actively managed ETF? That’s a bit counter-intuitive. The main benefits of ETFs are they are traded like stocks, act like mutual funds, and have low low Expense Ratios. I think I’ll be staying away from those ETFs. Also, if you don’t know what ETFs are, check out “The ETF Book”, that’ll explain it in great detail.

If you are investing in your own IRA and you are under 30, having an aggressive stock portfolio makes long term sense.

But in my personal experience, an aggressive strategy in an employer 401K (which most of us have) is essentially a giant gamble.

Any time you change jobs or get laid off, you have to “cash out” and roll your money into either an IRA or another employer’s 401k. You lose all benefits of an aggressive long term strategy. If your investment lost 25% there is no way of waiting until your fund shares bounce back.

I recently rolled over my 401k money from a previous employer into my current employer’s plan and wondered the same thing about losing dollar cost averaging by “cashing out” and buying into share prices which are now higher (since the stock market has been going up, up, up since I started investing years ago).

I think though to your question/concern, it doesn’t matter if you have a long term horizon. If your investment lost 25% like you said, you still will be putting money into another plan and have time for that money to grow right?

But I would like to see an article about cashing out or rolling over money and possible chance of loss of value / dollar cost averaging!

My comment is a bit late to this original posting, however I wanted to add my $0.02. I agree with the aggressive approach when you are younger, have a longer investment horizon and strong future earning capacity to make up potential losses. Of course, that probably only makes sense if you can handle the ups and downs, and can “stay the course” with your allocation, gradually reducing risk over time. If you sell all of the riskier assets at the first BIG drop and put everything in cash, it may not work out as well in practice.

Regarding specific asset classes, I prefer to have a decent exposure to foreign (about 25% total, with 10% in emerging), however am hesitant to go much beyond that because of the currency risk you alluded to. I’m don’t want to try to time currency markets, as I have no clue whether a weakened dollar over the last ten years means the trend will continue, or its due for an uptick against the world currencies, nor do I want to guess. I find some added safety in 75% of my portfolio being in investments that are in US dollars, so that I don’t have to worry too much about it. I do, however, have larger exposure to small and mid-cap stocks approaching 40% (typically Index funds) expecting that this may be a potentially higher risk/reward class compared with large cap stocks.

I’m 23 and I just started my first job post college. I have about $5,000 with no debt and can afford to add $300 a month. I want to invest in 2012. I want to set up a nice plan for myself. I don’t mind taking moderate risks but I also don’t want to lose everything. How shoulld invest my money over the next 7 years. What percentage should I keep where?

A simple 3 fund portfolio seems to give the biggest advantages for the least amount of research and work. A Total US Stock index fund, a total world index fund ex-US, and a bond index fund. This is Bogleheads style.

At 31, I’m allocated:

50% in Total US
30% in Global ex US
10% in Bonds
10% in Cash (high at the moment as I am potentially buying property soon).

This is allocated across all of our accounts. Checking, Brokerage, 401ks, IRAs, etc. Which is an important thing to mention. Folks should be counting the amount of cash they are holding in their checking account as part of their overall asset allocation, especially when you are young and that percentage of your total net worth is decently high.

I’ve heard the 100 – Age (and even 120 – Age) shortcut, but can never figure out why it makes sense to have any bonds or cash if you are still 20-30 years from retirement. They underperform stocks over that period every time and their only benefit is to hedge against short-term losses. With proper stock allocations, you can virtually remove all non-systematic risk and not sacrifice returns as much. When you age and your focus shifts to asset preservation, bonds/cash become more viable, but they are not going to help you retire (keep in mind that your investment horizon when you retire is still conceviably 20-30 years so you will always need some higher-risk investments.

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Where can you turn for simple non-judgmental financial advice as you start out? I'm David; I started Money Under 30 because I know how hard it is to get ahead. For seven years I've helped readers create better habits, beat debt and build real wealth. How can I help you?

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